Sweat equity is a funding model commonly used by startups.
It compensates a stakeholder for the work and time they contribute by giving them an ownership stake in a company.
It can be a useful way to fund a startup and attract top talent, but you need to understand how it works before deciding if it’s right for your business.
Luckily, you’ve come to the right place.
In this article, we’ll discuss the most important questions when choosing sweat equity as a funding model for your business.
🔹 What is sweat equity?
🔹 How does sweat equity work?
🔹 How do you calculate sweat equity?
🔹 What are the benefits and disadvantages of sweat equity shares?
🔹 What are sweat equity agreements, and what should they cover?
What Is Sweat Equity?
Sweat equity is the exchange of ownership for work and time contributed that adds value to the company.
The term ‘sweat equity’ originates from real estate investors, and for them, sweat equity refers to the work done by an owner to improve the value of an investment property before selling it.
In this case, the owner would exchange their actual sweat, in the form of manual labour when renovating a house, for value added to the house when reselling it.
However, the term is now more commonly used in the corporate world than in the real estate industry, particularly in the startup sector.
Let's look at an example of sweat equity to understand how it works in the startup sector.
💡 Startup Sweat Equity Case Study:
Olivia is a software developer with an idea for a great new mobile application.
Olivia decides to start a business and develop her application. She invests her savings of £100,000 to cover costs during the product development phase.
Once the app is ready to launch, the business will need to hire people with additional skills like marketing and business development, and it will need a way to pay them.
As the founder, Olivia now has the option to offer potential hires a salary, but this requires her to have or acquire the necessary upfront financial capital to pay those salaries.
Or she can offer them a sweat equity stake (or a combination of a lower salary plus sweat equity).
With the sweat equity option, Olivia can offer employees a percentage stake in the business in the form of shares instead of a salary.
Olivia doesn’t have an upfront cost with this option, which is why it can be a great option for cash-strapped entrepreneurs, but she is giving up potential future value by decreasing her ownership stake in the business.
If the potential employees believe the ownership interest they receive will be more valuable than the time and work they contribute to the business venture (i.e., they can sell their shares for more than they would have received in wages) they will be willing to exchange their “sweat” for equity.
How Does Sweat Equity Work?
Sweat equity works by issuing shares in an early-stage business.
Sweat equity shares can be issued as a direct exchange for a non-monetary contribution, like knowledge or work, or by issuing shares to existing employees at a discounted price.
Issuing discounted shares is typically done to retain existing talent, and it does require the employee to purchase the shares.
How to Calculate the Value of Sweat Equity
To calculate the value of sweat equity, you will first need to know the value of your business.
If you have received outside equity funding, valuing your business is easy.
If you haven’t, valuing your business will be more complex, but there are several ways to do it.
These include doing an asset valuation, using your price-to-earnings ratio, or using industry rules of thumb.
Once you know the value of your business, you can calculate sweat equity value by subtracting the total cash investment made by the founders from the business valuation.
What Are the Benefits of Sweat Equity?
Using sweat equity also has several benefits.
🚀 Increased productivity.
Employees are often motivated to be more productive if they have a stake in the business.
🚀 Aligned Incentives.
Founders and employees are nicely aligned towards the long-term success of the company.
🚀 It can help to recruit and retain top talent.
Talent that the business might not otherwise have been able to afford might be willing to work for cash equity if they believe the business has a lot of potential value.
🚀 It can reduce employee turnover and increase loyalty.
Employees are less likely to leave the business if they own shares.
What Are the Disadvantages of Sweat Equity?
There are also some disadvantages that start-up companies should be aware of before using sweat equity.
🚨 High administrative costs.
There are short-term costs to getting a sweat equity agreement drawn up and approved, and long-term costs to managing the scheme and keeping records.
🚨 Unrealistic financial expectations.
There is a risk of creating unrealistic expectations of financial rewards for employees, which can cause disgruntlement if they are not realised.
🚨 Dilution of share ownership.
As more shares are issued, the value of existing shares decreases. This can create a situation where founders lose control of the business if their ownership percentage drops below a certain threshold.
What Is a Sweat Equity Agreement?
A sweat equity agreement is a contract between business partners, or between a business and the stakeholder to whom they are issuing shares in exchange for work.
It is important to have a contract in place, as this protects both parties and establishes clear terms for what needs to be provided from both sides.
What Should Be Covered in a Sweat Equity Agreement?
At a minimum, this written agreement should cover the following:
🔹 The amount of equity to be issued to the stakeholder.
🔹 Milestones and performance criteria.
The agreement should establish the criteria involved in the equity being issued.
For example, it could specify that an employee must complete a project, complete the delivery of a product, or work for a specified period before being granted equity.
Clauses that govern the conditions under which either party can terminate the agreement should be included.
It’s important to note that sweat equity agreements are legal documents, so it is advisable to consult a lawyer when drawing one up, but templates are available online that you can use to get started.
This is a good template if your startup is based in the UK. If you are in the US or elsewhere, this is a good starting point.
What Are the Tax Implications of Sweat Equity for Startups?
Another thing to keep in mind is that sweat equity is considered a form of income by most tax authorities, including HMRC in the UK and the IRS in the US. As such, it must be included in the gross income of founders and employees for tax purposes.
However, several factors affect how sweat equity is taxed, including the value of the shares at the time of issue and whether it was issued directly or acquired by way of a stock option.
Discussing the tax implications of sweat equity in detail is beyond the scope of this article, but if you are in the UK, this article by Keystone Law will give you a good overview. If you are in the US, Meyers, Roman, Friedberg & Lewis is a good starting point.
How Can MOHARA Help Your Business with Sweat Equity?
As we have seen, sweat equity can be an excellent fit for cash-strapped startups that need to attract top talent for lower upfront costs.
MOHARA pioneered this approach and has many years of experience in providing sweat equity to high-potential startups.
For the right startups, MOHARA can provide sweat equity (reduced rates in exchange for equity) to help the company build world-class technology.
Why not get in touch and tell us about your idea and business plan to see if we would be a good fit as a partner?
Let's be pioneers together!